Investment Under Uncertainty, Heterogeneous Beliefs and Agency Conflicts

Abstract

We develop a structural model to investigate how risk, uncertainty about project quality, and asymmetric beliefs affect decision-making in dynamic principal-agent relationships. We consider a principal-agent environment in which a cash-constrained agent with a project approaches a principal for investments in the project. The payoffs of the project depend on the principal's investments and the agent's effort. The principal and the agent have imperfect information and differing beliefs about the project's intrinsic quality (with the agent being more optimistic), as well as asymmetric attitudes towards its risk. We characterize the equilibrium of the stochastic dynamic game in which the principal's investments, the agent's effort choices, the dynamic incentive contract between the principal and agent, and the project's termination time are derived endogenously. As an illustrative application, we use the model to study R&D investment. We calibrate the parameters of the model to data on the return distributions of pharmaceutical R&D projects. Numerical results show that optimism significantly influences project value, and that permanent and transitory components of risk have opposing effects on project value and duration.

Keywords: Investment, Agency Conflicts, Imperfect Information, Asymmetric Beliefs, R&D